TESTING THE RESILIENCE OF EUROPE’S INCLUSIVE GROWTH MODEL DISCUSSION PAPER DECEMBER 2018 Jacques Bughin | Brussels Jan Mischke | Zurich Tilman Tacke | Berlin Eric Hazan | Paris Pal Erik Sjatil | Paris Since its founding in 1990, the McKinsey Global Institute (MGI) has sought to develop a deeper understanding of the evolving global economy. As the business and economics research arm of McKinsey & Company, MGI aims to provide leaders in the commercial, public, and social sectors with the facts and insights on which to base management and policy decisions. MGI research combines the disciplines of economics and management, employing the analytical tools of economics with the insights of business leaders. Our “micro-to-macro” methodology examines microeconomic industry trends to better understand the broad macroeconomic forces affecting business strategy and public policy. MGI’s in-depth reports have covered more than 20 countries and 30 industries. 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Copyright © McKinsey & Company 2018 2 McKinsey Global Institute CONTENTS In brief Testing the resilience of Europe’s inclusive growth model Page 1 Different types of social contract may display specific resilience and vulnerability Page 3 Much of Europe has returned to growth, but its inclusiveness remains under pressure Page 8 Six megatrends could test the resilience of Europe’s inclusive growth model Page 12 The megatrends mean Europe may face higher inequality and more divergence Page 28 Action in three areas is required to strengthen Europe’s inclusive growth model Page 36 Technical appendix Page 44 Further reading Page 57 Acknowledgements Page 58 IN BRIEF TESTING THE RESILIENCE OF EUROPE’S INCLUSIVE GROWTH MODEL European countries have different flavours of welfare model, yet they share a history of solid social protection and a focus on inclusive growth, which has been under stress since the recent financial crisis. Although inequality across Europe has grown only moderately since the early 2000s, social divergence between and within some European countries has increased. Citizens’ trust of national and European Union (EU) institutions has fallen. Six global megatrends could widen income inequality and social divergence further to 2030, putting Europe’s inclusive growth model under even more strain. The EU is likely to be able to preserve the essence of its social contract only by delivering effective policies in response to the megatrends to restore social convergence in the EU, and by adjusting the parameters of its social contract. Our key findings include: Investment rates have not recovered to pre-crisis levels, trust in national governments is still falling in one-third of European countries, and populist parties have won greater shares of the vote. Market income inequality in Europe rose only moderately compared with other regions, and redistribution almost stabilised disposable income distribution in recent years. However, the cross-country picture is mixed. Nordic countries have achieved the largest income growth, but in Southern Europe, all income quintiles have lost between 1 and 3 percent a year of disposable household income, with the lowest-income households experiencing the largest losses. There could be cracks in the sustainability of the EU social contract in the next decade caused by six megatrends: ageing demographics; digital technology, automation, and artificial intelligence (AI); increased global competition; migration; climate change and pollution; and shifting geopolitics. Based on these trends, inequality may rise again, and divergence within Europe may increase. In a simulated “denial” scenario, in which the EU and European countries do not respond to the megatrends (and roll back current policies), a social contract centred on inclusive growth would seem elusive, as Europe would face prolonged economic stagnation, rising inequality, and growth in welfare costs outstripping gross income growth. But in a simulated “deliver” scenario, in which Europe scales up current policies (particularly on ageing, diffusion of digital and AI, and investment in the circular economy), Europe could rebuild solid income growth—in our simulation of 1.9 percent a year per capita to 2030, producing an additional €9,000 of per capita gross income that could fund additional public social spending. One of the EU’s most pressing challenges—even in the deliver scenario—could be rising inequality. Particularly digitisation and AI, but also global competition, could amplify skills premiums and put pressure on wages of routine jobs, superstar effects among firms and cities could continue, and both ageing and migration could further increase the wedge between top- and bottom-income households. What’s more, consensus forecasts project that Europe’s South is likely to diverge from, rather than reconverge with, Europe’s North, and a shift in global competition to digital may create yet more headwinds in Europe’s economically weaker geographies, threatening EU cohesion. Improved innovation and upgrades in human skills should be key priorities for Europe given that both can support inclusive growth. In all scenarios, the EU is likely to need to adapt the parameters of the social contract to cope with the megatrends, for instance embedding lifelong learning in the workplace and enforcing behaviour with respect to limiting pollution and overuse of natural resources. Europe will also need to increase, and better communicate, efforts to rebuild citizens’ trust in order to gain their support for the required changes ahead. TESTING THE RESILIENCE OF EUROPE’S INCLUSIVE GROWTH MODEL Behind the economic performance of countries—their GDP growth—lies a set of institutions that set the foundations: their social contracts.1 The main backbone of the social contract of the European Union (EU) is more or less defined by lower disparity in income generation and high redistribution to ensure inclusive growth, and high access to healthcare. Typically, income taxes are relatively high, public social expenditure relatively large, and coverage of social risk material.2 However, today the sustainability of Europe’s inclusive growth model and the EU’s social welfare–oriented contract and its local variants is subject to intense discussion in light of limited growth in median income, falling trust in institutions, discomfort with mass migration, worries about security and the resilience of global agreements, and a rise in populist politics that challenges the status quo.3 The perceived strains are sufficiently serious that European Central Bank executive board member Benoît Coeuré referred to them in a speech at Harvard in March 2013 in which he said, “What is at stake is nothing less than the sustainability of the European social market economy”.4 The critical question is whether perceptions that the EU social contract is breaking are justified, and, if they are, how the contract could be amended. This paper builds on research the McKinsey Global Institute (MGI) conducted in the context of our knowledge partnership with Friends of Europe for the #EuropeMatters project, and is the first in a forthcoming MGI series on the evolution and resilience of social contracts.5 This paper focuses largely on inclusive growth in the period to 2030.6 We concentrate on inclusive growth as this is the common backbone of Europe’s social vision and its different flavours of social contract.7 1 A social contract is a framework of settled relationships and agreements between individuals, companies, communities, and governing institutions, which aims to achieve goals such as security, liberty, inclusive prosperity, or sustainability. In this paper, we focus on the economic aspects of the EU social contract. 2 Daron Acemoglu and James A. Robinson, Why nations fail: The origins of power,